Can a trustee treat receipts or outgoings as being on capital or income account irrespective of the nature of the receipt or outgoing? Legal and tax advisers have expressed various views on the proper classification of receipts or outgoings where the terms of a trust provide a trustee with a power to classify receipts or outgoings as either on capital or income account. Much has been and will be said on this issue and on the application of Division 6 of Part III of the Income Tax Assessment Act 1936 (Cth) (the Act) in light of the recent decision of the High Court of Australia in Commissioner of Taxation v Bamford [2010] HCA 10 (30 March 2010) (Bamford). In addition to Bamford, a recent decision of the Full Court of the Federal Court of Australia (Full Federal Court), Forrest v Commissioner of Taxation [2010] FCAFC 6 (Forrest), has perhaps qualified a trustee's power to determine the character of a receipt in its hands in a slightly different context.
It is not uncommon to find a power granted to a trustee that gives it the ability to classify receipts or outgoings as either capital or income. Such powers are expressed in a variety of forms, but they seemingly give the trustee an unfettered power to classify the amount received or disbursed.
The scope of this classification power in the context of the taxation of beneficiaries and trustees of a trust has never been put beyond doubt, especially in relation to the application of the provisions in the Act. Subsection 97(1) of the Act relevantly provides:
... where a beneficiary of a trust estate ... is presently entitled to a share of the income of the trust estate:
(a) the assessable income of the beneficiary shall include:
(i) ... that share of the net income of the trust estate... (Emphasis added).
Due to the manner in which subsection 97(1) of the Act operates, the ability to turn income into capital or capital into income could alter the incidence of tax - that is to say, it could affect whether any beneficiary or particular class of beneficiary is subject to tax on some or all of the net income of the trust or whether the trustee is subject to tax on some or all of the net income of the trust.
In Cajkusic v Commissioner of Taxation (2006) 155 FCR 430 (Cajkusic), the Full Federal Court dealt with a power to characterise receipts and outgoings for the purpose of determining the 'income of the trust estate' in circumstances where the Commissioner of Taxation (Commissioner) had denied a deduction in the computation of the net income (for tax purposes) of the trust. The Full Federal Court held that the denial of the deduction for the purpose of determining the net income did not alter the ability of the trustee to characterise the outgoing as being on revenue account for the purpose of determining the 'income of the trust'1. In exercising this power to classify the outgoing, the effect was that there was no 'income of the trust' for the purposes of subsection 97(1) of the Act and accordingly no beneficiary was subject to tax on any of the net income (for tax purposes) of the trust. Rather the trustee was liable for tax on the whole of the net income under section 99A of the Act.
The meaning of the phrase 'income of the trust estate' for the purposes of subsection 97(1) of the Act was also one of the issues dealt with by the Full Federal Court in Bamford v Commissioner of Taxation (2009) 176 FCR 250. At issue was whether the net capital gains arising from CGT events in respect of CGT assets (i.e. the disposal of real property in this case) for a particular year of income could be included in the 'income of the trust estate' under subsection 97(1) of the Act. The trust in question was a discretionary trust, which contained a clause empowering the trustee to determine whether a receipt was to be treated as being on income or capital account. The net capital gain derived by the trustee was included in the distribution made to the beneficiaries of the trust. The Commissioner took the view that the net capital gain could not form part of the 'income of the trust estate' under subsection 97(1) on the basis that 'income of the trust estate' only referred to income according to ordinary concepts. The trustee was consequently assessed under section 99A of the Act and liable to pay tax at the top marginal rate as there was no income of the trust estate to which any beneficiary was presently entitled.
The Full Federal Court held that the phrase 'income of the trust estate' in subsection 97(1) of the Act did not mean income according to ordinary concepts, but rather meant that which is treated as income under the terms of the trust instrument for the purpose of fixing beneficiary entitlements. His Honour, Justice Emmett stated that 'where a trust instrument permits the trustee to treat a capital receipt as income for the purposes of fixing the entitlements of beneficiaries to distribution, a beneficiary who thereby becomes entitled to a share of that capital gain is presently entitled, within the meaning of s 97, to that part of the income of the trust estate'.2 Likewise, their Honours, Justices Stone and Perram, held in Bamford that the decision of the Full Federal Court in Cajkusic 'seems to us to require that the expression 'the income of the trust estate' be interpreted as meaning the income of the trust as understood in trust law'.3 As such, their Honours were of the view that 'the terms of the trust may have the effect of altering the income of the trust for s 97 purposes'.4 Both the taxpayer and the Commissioner of Taxation were granted special leave to appeal against the decision of the Full Federal Court.
The Commissioner's appeal in relation to this issue was unanimously dismissed by the High Court in Bamford. The High Court rejected the Commissioner's argument that the expression 'income of the trust estate' only included income according to ordinary concepts. The High Court upheld the role of the trust instrument, and, in particular, the Court emphasised the need to have regard to the general law of trusts in construing the expression 'income of the trust estate'. In this regard, the High Court said:
Th e very juxtaposition within s 97(1) of the defined expression 'net income of the trust estate' and the undefined expression 'the income of the trust estate' suggests that the latter has a content found in the general law of trusts, upon which Div 6 then operates.5
e very juxtaposition within s 97(1) of the defined expression 'net income of the trust estate' and the undefined expression 'the income of the trust estate' suggests that the latter has a content found in the general law of trusts, upon which Div 6 then operates.5
The High Court also quoted, with approval, the following from the judgment of Justice Sundberg in Zeta Force Pty Ltd v Commissioner of Taxation (1998) 84 FCR 70:
The words 'income of the trust estate' in the opening part of s 97(1) refer to distributable income, that is to say income ascertained by the trustee according to appropriate accounting principles and the trust instrument.6
It now seems open for a trustee, subject to the terms of the trust, to permit the inclusion of a capital amount in the 'income of the trust estate' for purposes of subsection 97(1) of the Act.
The re-characterisation of receipts is not an issue that is confined to taxation law. In a non-tax context, the Supreme Court of New South Wales in Wood v Inglis [2009] NSWSC 601 held that the trustee of a discretionary trust was entitled to treat unrealised capital gains as income, although it must be said that this particular point was not the sole reason for arriving at this view with respect to powers of classification.
In Forrest, the Full Federal Court considered the terms of a trust known as the Minderoo Trust that contained a power to re-classify receipts and outgoings. Amongst the issues addressed by the Full Federal Court was whether deductions claimed by the taxpayer for interest expenses were allowable in circumstances where the taxpayer borrowed money to acquire units in the Minderoo Trust. The issue of deductibility turned on whether the interest expense was incurred in the course of gaining or producing assessable income. Whether this nexus was satisfied in turn depended upon whether the taxpayer was presently entitled to a share of the income of the trust. A fixed trust with respect to the income of the Minderoo Trust would have resulted in some or all of the net income of the trust being required to be included in the beneficiary's assessable income, thereby demonstrating the nexus between the interest expense and the production of assessable income. Ultimately, all of this was dependent upon the construction of the relevant clauses of the trust deed for the Minderoo Trust as the nexus between the interest expense and income producing activity would not necessarily have been present if the trust was a discretionary trust.
Clause 3 of the trust deed of the Minderoo Trust provided that the beneficial interest of the fund was divided into the Unit Component, which was held on trust for the unit holders and the Discretionary Component, which was held on trust for the Discretionary Beneficiaries. The Unit Component was defined to mean the issue price of the units, the Fixed Income (as long as the trust was not taxed as a company) and the accumulated income, if any, in the event that the trust was taxed as a company. The term 'Fixed Income' was defined to mean '… all Income other than income comprising the Discretionary Component'.
The terms 'Discretionary Component' and 'Income' were defined as follows:
Discretionary Component means all Income which represents realised and unrealised capital gains derived from the holding or realisation of any Investment;
…
Income means income produced from the investment, management or realisation of the Fund (or any part of the Fund) and includes any accretion, gain (whether or not realised), payment or receipt determined by the Trustee to be Income;
The Commissioner submitted that the Minderoo Trust was a discretionary trust because clause 12 of the trust deed gave the trustee a seemingly unfettered discretion to classify any amounts received or disbursed as income or capital, in spite of the beneficial interest in the Minderoo Trust being divided into a Unit Component and a Discretionary Component.
The Full Federal Court held that the trust was a hybrid trust on the basis that the trust deed when read as a whole made clear that the objective intention of the settlor and the trustee was that income other than capital gains was to be held on a fixed trust and that capital gains were to be held on a discretionary trust. In arriving at this view, the Full Federal Court made the following comments concerning the power of the trustee to classify income:
In our opinion, the power conferred by clause 12 cannot be exercised by the trustee wrongly to classify a receipt as capital gain, when the receipt is, in truth, income, and thus deprive the appellant of his interest in the unit component of the trust. Clause 12 is not an unlimited power to be exercised in the trustee's unconfined discretion.7
The Full Federal Court also noted:
Clause 12.1 is a power to make an honest administrative determination whether receipts are on capital account or income account. It is not a power to determine, in the trustee's unconfined discretion, whether a receipt 'represents realised or unrealised capital gains'.8
Further, in determining the precise nature of a trust, the Forrest case is a reminder that it is necessary to have regard to the terms of the trust deed as a whole, rather than focusing attention on a particular part of the deed - as the Full Federal Court said:
Clause 12.2(a) is a power to determine how a distribution to beneficiaries is classified. That limited power is not a power which is capable of altering the beneficiaries' rights. Clause 12 is to be read consistently with the balance of the Trust Deed and an appreciation that it contains various powers of an administrative character.9
The Full Federal Court in Forrestheld that in construing a trust deed, a distinction should be made between provisions that define beneficiaries' rights (i.e. clauses that set out the beneficiaries' entitlements or interests) and provisions that are merely administrative in nature (i.e. clauses that exist to enable the trustee to perform their duties, such as clauses that give the trustee the power to classify amounts as income or capital). The need to have regard to the entire deed is underscored where the trust has different beneficiaries with respect to income and capital in order to ensure that trustee properly discharges its duties and clauses of an administrative nature should not be construed to alter the entitlements and rights of beneficiaries.
The decision of the Full Federal Court in Forrestheld that, in the context of the particular trust deed in question, the power to re-classify receipts and outgoings was an administrative power of trustee. This should not, however, be interpreted as a general proposition as the decision was based on a construction of the particular terms of a particular trust deed. The Full Federal Court was not required to express any view on the application of section 97 of the Act.
In the face of much uncertainty regarding the application of subsection 97(1) of the Act, the Commissioner issued Practice Statement PSLA 2009/7 on August 2009 which sets out his view on the application of section 97 of the Act. In summary, his view is that:
We observe in passing that there appears to be some internal inconsistency in the Commissioner's view as expressed in PSLA 2009/7. On the one hand, the Commissioner appears to be stating that the expression 'income of the trust estate' is a gross concept under the first proposition above. But the Commissioner also appears to be stating that in determining a beneficiary's share of the 'income of the trust estate' it is necessary to make allowance for the revenue outgoings under the second proposition (i.e. 'income of the trust estate' is a net concept). This should be compared with the view expressed by the Full Federal Court (comprised of Bowen CJ, Deane and Fitzgerald JJ.) in Federal Commissioner ofTaxation v Totledge Pty Ltd(1982) ATR 830 at 838 and also the High Court's decision in Bamford at paragraph 39.
In light of the High Court's decision in Bamford, the first proposition above is incorrect.
Whilst Forrest perhaps qualifies a trustee's power to determine the character of a receipt in its hands, it is debatable whether it supports the Commissioner's view as expressed in PSLA 2009/7 in relation to the re-characterisation of receipts and outgoings. At most, Forrest puts a limit on the trustee's administrative power to re-characterise receipts and outgoings by requiring the trustee, adopting the Commissioner's words in the Decision Impact Statement on Forrest (issued on 4 May 2010), 'to honestly classify receipts according to law'. However, the Commissioner's view on the re-characterisation of receipts and outgoing has arguably been weakened in light of the Bamford decision, which arguably support the view (or at least did not reject it) that it is permissible for trust instruments to include capital amounts in the 'income of the trust estate' for purposes of subsection 97(1) of the Act.
As can be seen from the brief survey of the above case law, the ability of a trustee to re-characterise outgoings and receipts is not straight forward. The effect of any such re-characterization needs to be carefully considered by the trustee as it could alter the tax liabilities of the beneficiaries or expose the trustee to unintended tax liabilities (or both). At the same time, the decision in Forrestis a timely reminder that the trustee's power to re-characterise outgoings and receipts is not necessarily without limit. Further, as the High Court in Bamford has affirmed, the role of the trust instrument in determining the income of the trust estate for section 97 purposes, the definitions of income and capital, together with the trustee's power to re-characterise amounts should be carefully considered when drafting and interpreting trust deeds. The legal and tax effect of clauses granting powers to re-classify receipts and outgoings will undoubtedly give trustees much to consider in the exercise of their discretion - whether in a tax or non-tax context.
1 Cajkusic v Commissioner of Taxation(2009) 155 FCR 430 at 438 at [30]. 2 Bamford v Commissioner of Taxation(2009) 176 FCR 250 at 263-264 [59]. 3 Bamford v Commissioner of Taxation(2009) 176 FCR 250 at 266 [73]. 4 Bamford v Commissioner of Taxation(2009) 176 FCR 250 at 267 [77]. 5 Commissioner of Taxation v Bamford[2010] HCA 10 at [36]. 6 Zeta Force Pty Ltd v Commissioner of Taxation (1998) 84 FCR 70 at 74-75. 7 Forrest v Commissioner of Taxation[2010] FCAFC 6 at [27]. 8 Forrest v Commissioner of Taxation[2010] FCAFC 6 at [28]. 9 Forrest v Commissioner of Taxation[2010] FCAFC 6 at [29].
In proceedings brought in the Federal Court of Australia, ASIC has successfully established that one of the world’s largest investment managers contravened the ASIC Act when it made a series of...
2024 is off to brisk start in the cyber, privacy and data space – regulatory developments in cyber security and artificial intelligence (AI) continue at pace.
A recent Federal Court decision provides a useful distillation of the key principles that apply to unreasonable director-related transactions under s 588FDA of the Corporations Act.